Doing Too Little, Too Late, to Fix Europe's Economy

A new year has brought new ideas for solving Europe's economic problems. This time, they include variations on quantitative easing. The European Central Bank's governing council will meet Jan. 22, and markets eagerly wait to see whether its president, Mario Draghi, will in fact implement one of these new solutions, since the more traditional method of buying sovereign bonds is unfeasible. Whether the bank implements them depends on how dangerous it considers deflation to be. But unfortunately for Europe, none of them truly solves the underlying problems affecting Europe: economic stagnation and low growth.

Technically, the European Central Bank will consider three methods by which it would purchase sovereign bonds in the eurozone. One method represents a more traditional approach to quantitative easing, under which the bank would buy sovereign bonds of every eurozone member proportionate to the size of each member's economy. The other two methods deviate from the norm. Creative as they are, they, like the more traditional approach, are deeply flawed.

Caught in a Trap

Europe's most fundamental problem is low growth. Its subsidiary problems — high unemployment and low inflation — stem from low growth. Since resolving the core issue would also resolve the subsidiary issues, most attempts to revive the economy have focused on stimulating growth. Studies show that in Europe the best way to stimulate growth is through small and medium-sized enterprises, or SMEs, which constitute 99 percent of all businesses. It is little surprise, then, that almost every action undertaken by the European Central Bank has been to place money in the coffers of SMEs.

And yet in 2014 those actions proved somewhat ineffective. European businesses typically receive funding from banks, not from bonds purchased in capital markets. But the asset-backed securities market, through which SME loans are bundled as bonds and sold, is considerably less developed in the European Union than it is in the United States. So when the bank tried to buy asset-backed securities to stimulate SMEs, it found that there were simply not that many bonds the bank could buy.

Under another policy, known as the TLTRO program, the European Central Bank offered cheap loans to banks on the condition that they then pass the money along to the market. But that policy, too, fell flat; most banks turned down the offer. This was a revelation: It was not that banks did not have money to lend SMEs; it was that SMEs were not applying for loans in the first place. The market was unfavorable for SMEs to invest in their own businesses, so there was low demand for capital.

The way to stimulate growth in such a market is to improve the business environment. Some in the eurozone called for looser fiscal policies — removing taxes and increasing investment, for example — while others called for structural reform — removing bureaucratic barriers and making the environment more conducive for business. For his part, Draghi advocated structural reform and looser fiscal policy to complement the monetary policy over which he had control.

Unfortunately each policy has powerful inhibitors within the eurozone. The countries that need structural reform most strongly, France and Italy, are the least likely to implement them, since the political costs for doing so are so high. The country best equipped to loosen its fiscal policy, Germany, has little incentive to do so; it believes in keeping spending under control, and blames the rest of Europe for the Continent's economic hardships. Thus, many in Europe believe the European Central Bank is the only institution able to take the necessary action.

Meanwhile, two other menaces have been creeping up on the Continent: deflation and artificially low interest rates for peripheral eurozone countries. The former is a result of Europe's economic problems, and the latter is a result of Draghi's hints toward quantitative easing.

Preliminary figures released Jan. 7 revealed that the eurozone officially moved into deflation in December. If deflation persists, it could discourage consumer spending, especially if Europeans believe prices will continue to drop. For the European Central Bank, it would be best to prevent deflation from taking hold in the first place, rather than escaping from it later.

One way to prevent deflation is to loosen monetary policy dramatically. Growing the European Central Bank's balance sheet by increasing the funds available in the market should artificially raise inflation levels. But unless measures are taken to redress the root causes of deflation, any reprieve Europe gets will be temporary at best.

With just such a stimulus in mind, Draghi discussed plans to grow the balance sheet by injecting some 1 trillion euros ($1.2 trillion) into the market. Ideally, that money would go straight to SMEs, but again, there are simply not that many SME-related bonds for them to buy. Only sovereign bonds can support a cash injection of such magnitude, so the market now believes it is inevitable that the European Central Bank will buy sovereign bonds.

It was this kind of guidance from Draghi that drove interest rates down. Over the past year, Draghi has gradually convinced the market that quantitative easing is imminent, and by fostering that belief, he has been able to accomplish some of the effects of quantitative easing without actually implementing the policy. Bond yields in Europe's periphery have dropped to record lows; investors have bought sovereign bonds ahead of the expected price rise that would result from the European Central Bank's purchasing program. In theory, these low borrowing costs should keep pressure off France and Italy and enable them time to undertake structural reforms (even if they have yet to do so). The specter of the bank's purchasing program has also devalued the euro as the market anticipates the negative effect it would have on the exchange rate.

In 2012, Draghi talked his way out of a crisis without having to spend any money whatsoever. But now, if markets stop believing in the inevitability of quantitative easing, peripheral bond yields would fly back up to reasonable levels. This would be particularly problematic for Italy and France, whose budgets are still under review by the European Commission. The value of the euro may go up, too, which would undermine competitiveness.

So Draghi is now caught in a trap of his own making. Failing to implement the policies he intimated he would may shock the economy at a particularly sensitive time, considering Greece's potential departure from the eurozone.

The Great Pretender

The market is poised for some form of quantitative easing to be announced at the Jan. 22 meeting. But it is unclear precisely what option the bank will adopt, if it adopts any of them, since they are all so unattractive.

The first, more traditional option would involve buying sovereign bonds of all eurozone members. This is the simplest, most coherent and most widely discussed option. However, it has been rejected by Germany, which does not want the bank to take on the risk of peripheral states, since the eurozone, of which Germany is the largest member, would have to underwrite them.

Under the second option, the bank would delegate the purchasing of sovereign bonds to the national central banks of each country. Though the funding would still come from the European Central Bank, the risk would be kept inside each country. So if a member defaulted, the European Central Bank would not be left holding worthless sovereign bonds. Theoretically, this option would make it easier to cut off the offender without incurring too much collateral damage. It would also enable the European Central Bank to hit its balance sheet target while keeping peripheral bond yields low. Importantly, Germany would accept this option.

However, there are concerns over the political message this option would send. The European project is supposed to promote integration. Separating the liabilities of each member state, making it easier to cut them loose if they become dead weight, actually discourages integration. The European Central Bank would weaken itself by empowering national central banks, loosening the ties that bind the structure together.

According to the third option, the European Central Bank would buy only AAA-rated sovereign bonds. The most optimistic target market size would be half the size of the overall sovereign bond market. It is unclear whether that would be enough to grow the balance sheet as much as the bank would like. The main drawback to this plan is that it would leave the peripheral bonds unsupported, causing the market to desert them and allowing their yields to rise again — something Draghi would prefer to avoid.

Of course, none of these solutions is perfect. The first is unworkable due to German resistance. The second undermines the very foundation of the eurozone. The third fails to solve one of the key issues facing the European Central Bank. Until these two new options emerged, the debate over quantitative easing centered on whether the European Central Bank would be able to buy peripheral bonds, ignoring Germany's objections in the process. A confrontation was inevitable. Draghi could do nothing and clash with the market, or he could implement the type of quantitative easing that Germany opposed and clash with Berlin. The new solutions provide a way defuse that confrontation.

Whether the European Central Bank adopts quantitative easing, regardless of the flaws of each option, depends on how dangerous it considers deflation to be. If it sees deflation as a mortal danger, options two or three could be used to inject money into the system, their flaws notwithstanding. If the bank believes it can live with deflation for the time being, Draghi can be expected to use these new options to keep the markets on their feet, anticipating quantitative easing and trapped in its ownership of sovereign bonds, leaving Italy and France free to implement reform of their own. But considering the bank's track record, whichever option it chooses will be too little and too late to be effective.

Under the current circumstances, Draghi may bide his time, much as he has in the past. Low oil prices and a weak euro could stimulate the economy in ways the European Central Bank and national governments have been unable to. The longer these forces are allowed to work on the European economy, the more chance there is of an organic pick-up in growth, which could eventually help to solve Europe's inflation and unemployment problems. Perhaps Draghi, the great pretender, will yet again be able to talk his way out of trouble.